The big opportunity in emerging market debt

The writer is a portfolio manager at GMO

Investors who have participated in financial markets since 2010 have only known a rising dollar and the significant impact it has had on the relative returns of assets not denominated in the US currency.

More seasoned investors will observe that the dollar takes roughly decade-long swings: when it looks rich on most currency valuation metrics, as it currently does, its decline portends a boost to foreign stocks and bonds, especially those in emerging markets.

Aside from the translation effect that makes local currency debt more valuable for international investors with dollar-based portfolios in such a trend, there are other reasons to be bullish on emerging market debt given high interest rates, shifting growth differentials and diversification considerations.

Of course, it is hard to spot inflection points after so many years of nonstop dollar strength. However, most often, it is in such uneasy times that contrarian positions can pay off the most. The key question is: can the US be even more exceptional than it is now to continue the dollar’s upward trend?

The glass-half-empty Frenchwoman in me believes geopolitical risks (the Russia-Ukraine war, Middle East conflict, China-Taiwan tensions, etc) and a low-growth environment in most places outside the US might signal that we have not yet reached such an inflection point. In a world of risk aversion, the dollar can indeed remain king.

The glass-half-full American in me, though, sees factors such as sluggish growth and lack of structural reforms in recent years already priced into non-US currencies.

In other words, investors are now more highly compensated for the risks associated with emerging market currencies than they have been for more than a decade. Already many emerging market assets delivered strong returns in 2023 despite ongoing dollar strength. Any downward trend in the US currency could be a major spur for non-dollar assets.

We looked at a basket of local currencies weighted in line with benchmarks for emerging market debt and equities. We estimate the dollar is 8 per cent and 15 per cent overvalued versus the currency baskets associated with local debt and emerging markets equities, respectively. These valuations are reminiscent of those at the start of the last dollar decline cycle in 2003-2011.

Another factor supporting local debt is high interest rates: in both nominal and inflation-adjusted terms, current emerging markets interest rates are back to the 2003-2011 average. It is extremely rare to get this combination of cheap currencies with high rates — and it generally does not last long.

The growth differential picture is a little murkier. At the start of the last dollar decline cycle, the growth differential between emerging markets and the US was very high. This was powered by China’s post-financial crisis investment spending, which lifted commodity prices and, in turn, capital flows to emerging markets countries. More recently, amid lower overall global growth, this differential has waned.

There are signs the tide is turning and in a way that favours local debt exposure over emerging market equities. Countries that feature heavily in local debt market benchmarks are catching up with the economic growth of heavyweights in emerging markets equities indices. The former includes Indonesia, Brazil, Poland and later this year India when it is added to JPMorgan’s benchmark emerging-market debt index. Recent laggard Turkey also seems to be turning a corner after years of poor, unorthodox policies.

Outside of main debt benchmarks, there are also smaller rising stars in emerging markets local debt such as Costa Rica, the Dominican Republic and Jamaica that have been able to leverage US exceptionalism through links such as remittances and tourism thanks to positive macroeconomic management and structural reforms.

The IMF projects that the economic outperformance of countries in the currency basket for emerging market equities over local debt index constituents will fully dissipate in the next five years. This makes local debt a compelling diversifier to emerging markets equities. Further, the local debt asset class is seeing more “frontier” markets join — Uruguay most recently — expanding the opportunity set. The IMF projects frontier gross domestic product growth of 4.5 per cent for 2024-2028 versus 3.5 per cent for the existing local debt basket. Investing in these frontier opportunities via emerging market equities is not a meaningful prospect.

The bottom line: based on our reading of valuations in particular, we anticipate looking back on this current period as an attractive entry point for emerging market local debt.

GMO is an investor in emerging markets securities